You Have To Admire the Persistence of E&Y’s Partners

Piggybacking on previous decisions by the Fourth, Seventh and Eleventh Circuits and district courts in Maryland, Tennessee, California and Illinois, the Court of Appeals for the Federal Circuit recently held that an E&Y partner who sold a partnership interest in exchange for stock was taxed on the value of the stock in the year it was received, rather than when it was subsequently released from escrow.

In Hartman, the taxpayer was a partner in Ernst & Young’s IT consulting business. The partners sold the business to Cap Gemini, a French corporation, in exchange for Cap Gemini stock, and signed an employment agreement to work for a new entity owned by Cap Gemini. Important details relative to the stock proceeds include:

The stock was placed into an individual account in Hartman’s name at Merrill Lynch, effectively acting as an escrow.

The stock could not be withdrawn from the Merrill account and sold by Hartman for four years and 300 days following closing. This was done to prevent all of the E&Y partners from selling the Cap Gemini stock at once and diluting its value.

During the time the stock was restricted, Hartman had full dividend and voting rights.

The restricted shares would be forfeited upon three conditions: If Hartman terminated his employment, violated his employment agreement, or was fired for cause.

In the event Hartman was terminated for “poor performance”, he could forfeit 50% of the restricted shares, but could also receive all of the shares pending a review.

Hartman initially reported the value of the stock as having been constructively received in 2000, the year of the sale. After later discovering that some of his former E&Y partners had filed amended returns to remove the escrowed value from the 2000 return, however, Hartman followed suit.

The Claims Court initially found that Hartman had constructively received all of the shares of Cap Gemini common stock in 2000, and that he had properly reported the gain from the transaction on their income tax return for 2000 and thus was not entitled to a tax refund. For a discussion of the “constructive receipt” rules for cash basis taxpayers, see here.

The Federal Court of Appeals affirmed the Claims Court, reaching the same conclusion as all the other courts that have decided a “Cap Gemini” case: the stock was constructively received by the selling taxpayer — and thus included in taxable income — during 2000. From the court:

…although the accredited consulting partners’ right to “sell, assign, transfer, pledge, grant any option with respect to or otherwise dispose of any interest” in the Cap Gemini common stock was restricted, the Cap Gemini shares here were set aside for each accredited consulting partner in a Merrill Lynch account in each partner’s name, and the partners were able to receive dividends from and vote the shares during the period of time in which the sale of the shares was restricted. The risk of a decline in the value of the shares and the benefits of any increase in the value of the shares accrued entirely to the accredited consulting partners. Under the agreement, the shares immediately vested in the partners to ensure that the shares would not be treated as deferred compensation for future services.

Furthermore, in distinguishing Hartman’s plight from a previous decision that favored the taxpayer, the court told the former E&Y partner to lay in the bed he’d made:

Unlike Patton, Mr. Hartman and the other accredited consulting partners agreed to condition receipt of their shares on satisfaction of their own contractual obligations under the Partner Agreement and their employment contracts with CGE&Y. Under such circumstances, Mr. Hartman cannot now be heard to complain that such restrictions undermine his constructive receipt of the shares. The Claims Court rightly found that “Mr. Hartman voluntarily agreed to accept his share of the transaction proceeds with these limitations.” The fact that Mr. Hartman voluntarily agreed to subject himself to the restrictions imposed by the Partner Agreement cannot defeat constructive receipt.

There are still other E&Y Cap Gemini cases in the pipeline, and something tells me these guys won’t rest until they’ve exhausted every opportunity to have anyone and everyone hear their side of things, including but not limited to Judge Judy, the court of public opinion, and the cast of the former NBC sitcom Night Court. But unless Judge Harry T. Stone is feeling particularly generous, there’s no reason to believe any other partner will find a more attractive result.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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